WRAPUP 2-US services activity stays strong in July, input costs rise

The US services sector maintained strong growth in July, but supply constraints and rising input costs may keep inflation elevated, supporting expectations of a Federal Reserve interest rate hike.

The U.S. services sector maintained a strong pace of growth in ​July, but strong demand is colliding with supply constraints, driving up input costs for businesses and ‌potentially ​keeping inflation elevated for a while. The survey from the Institute for Supply Management on Wednesday added to manufacturing data this week in suggesting that the economy started the third quarter on a solid note, despite headwinds from the U.S.-Israeli war with Iran, now in its sixth month. Most economists viewed the data as supportive of expectations that the Federal Reserve would raise interest rates this year.

"The latest ISM Services report underscored that the U.S. economy ‌remained on solid footing entering the second half of the year," said Priscilla Thiagamoorthy, a senior economist at BMO Capital Markets. "But, the combination of stirring price pressures and a still-robust demand backdrop is likely to reinforce a higher-for-longer policy stance at the Fed." The ISM's nonmanufacturing purchasing managers index inched up to 54.1 last month from 54.0 in June. A reading above 50 indicates growth in the services sector, which accounts for more than two-thirds of U.S. economic activity. Steve Miller, ISM Services Business Survey Committee chair, noted that "tariff impacts and the Middle East conflict continued to be mentioned by respondents, but much less frequently ‌than in prior reports."

Thirteen industries, including retail trade, information, construction, public administration, utilities as well as mining, finance and insurance reported growth. The healthcare and social assistance sector was one of the four industries that contracted last month. Comments from purchasing managers highlighted growing cost pressures, with some ‌in the transportation and warehousing sector saying that while conditions were largely unchanged from June, prices continued to rise "driven mainly by fuel and labor costs." Some businesses in the utilities sector reported that "electric utility materials continue to be in high demand, causing competition among utilities for production slots." Others said "more suppliers are requiring progress payments or a down payment on goods."

Businesses in the agriculture, forestry, fishing and hunting sector said volumes were "slightly down for the year." Some wholesalers reported that "lumber supply is tighter, and freight rates and availability are challenges." They also noted that "many of our builders are pushing back hard on price increases." The survey's measure of new orders received by services businesses jumped to 57.2 from 55.1 in June, likely related ⁠to ongoing front-loading as ​businesses try to avoid shortages and higher prices from the Middle East conflict. ⁠The recently ended FIFA World Cup tournament also likely provided a lift. Strong orders would suggest that domestic demand, mainly consumer spending and artificial intelligence-related business investment, retained its robust pace of growth early in the third quarter. New orders were also boosted by strength in exports. But growth in backlog orders slowed considerably.

SUPPLIERS TAKING LONGER TO DELIVER Suppliers continued to struggle ⁠to keep up with demand. The survey's measure of supplier deliveries slipped to 52.8 from 54.4. A reading above 50 indicates slower deliveries.

The ISM said comments from purchasing managers noted that "some smaller suppliers are starting to be stressed financially, causing delays in shipments, missed shipments and other issues." It said others reported that "lead times are ​doubling on specific electrical conductor." Among the products in short supply last month were aluminum, electronic components, memory components and steel.

The survey's measure of prices paid by businesses for inputs increased to 70.3 from 67.7 in June. Prices increased for a range of products, including ⁠aluminum, beef, computers and related items, copper, paper and software licensing. Higher services input costs would suggest inflation was set to pick up after slowing in June on the back of a retreat in energy prices when the ceasefire between the U.S. and Iran took hold. Economists have warned that underlying inflation could remain elevated even if oil prices dropped because of the ⁠AI buildout. ​The Fed last week left its benchmark overnight interest rate in the 3.50%-3.75% range. Three members of the U.S. central bank's policy-setting committee dissented, preferring a quarter-percentage-point hike.

Despite strong order growth, services sector employment contracted last month, with the ISM noting that some businesses reported "seeing a small reduction at the moment, some coinciding with AI implementation." The survey's employment sub index dropped to 47.4 from 51.2 in June. This gauge has contracted in 12 of the last 18 months. The decline together with a separate report from ADP showing private employment increased by 44,000 jobs in July after rising 95,000 in ⁠June suggested that job growth has slowed after surging in the spring. Both the ISM and ADP employment report have, however, not been good predictors of nonfarm payrolls in the Labor Department's closely watched employment report.

Economists continue to view the labor market as remaining in a "slow-hire, slow-fire" ⁠mode, which they say should allow the Fed to focus on inflation. A Reuters ⁠survey of economists expected July's employment report on Friday to show nonfarm payrolls increased by 80,000 jobs in July after rising 57,000 in June. The unemployment rate is forecast holding steady at 4.2%. There is, however, a risk the jobless rate could edge higher after a Conference Board survey last week showed the share of consumers viewing jobs as "plentiful" dropped in July to the lowest level since February 2021.

"Businesses are hiring less due ‌to the extra cost pressure created by the jump ‌in energy prices and AI, which is boosting the productivity of existing workers and making medium-term staffing needs harder to judge," said Samuel Tombs, chief ​U.S. economist at Pantheon Macroeconomics.